Don’t Always Believe the “Experts”
By: Prof. Pierre Fournier
If you find yourself listening to someone pontificate about where the market is going, try to change the subject or look for an escape.
Interest in investment is hitting new highs. Discount brokers are now flooded with applications and trading volumes are surging. Despite this renewed focus, some misunderstandings persist about the realities of investing.
To illustrate, let’s deconstruct a conversation on investment that you might have with a friend, colleague, or advisor. It goes: “A guy on TV says the economy is strong and stocks are going up. It seems like a good time to invest. I don’t see much of the downside so I’m buying high-dividend stocks for my RRSP.”
“A guy on TV”
Many investors think there are people who know where the market is going on the short time horizon. Experts who know something the rest of us don’t. The reality is, they don’t. While their insights may be interesting and unique, any conclusions related to market timing aren’t worth the cup of coffee you’re drinking. It’s impossible to call the market level a week, month, or even a year from now with enough consistency to be useful. Stock prices are determined by a myriad of factors, many of which we are unaware of until after they’ve emerged.
“The economy is strong. I’m buying.”
What lies at the core of most market calls is an economic forecast, which is unfortunate because the connection between what the economy is doing and where the stock market is going is flimsy at best. It’s true that economic activity affects corporate profits, which ultimately drive stock prices, but the correlation is sloppy and unpredictable.
Mr. Market is not paying attention to today’s economic headlines. Instead, he’s focusing on what the news might be in three to six months from now. The corporations in which you are investing aren’t reading the headlines either. They’re too busy trying to move their businesses ahead.
“An excellent time to invest”
For an investor with a multi-decade time frame, anytime is a good time. However, certain points in time will be more prospective than others. These are periods when returns are projected to be higher based on fundamentals like rising profitability, low valuations, and/or extremely negative investor sentiment. To be clear, these factors won’t tell you what is about to happen, but they will provide a tailwind over the next three to five years.
“Not much downside”
When you own a stock, the range of possible outcomes is always wider than you would expect. It’s hard to conceive of a holding going down 20, 30, or 40 percent, especially when things are going well. Unfortunately, recent price moves have no predictive value. They just provide false comfort.
The future of a stock that has recently done well is just as uncertain as one that has not. Indeed, it may be riskier because its price-to-earnings multiple is higher (if profits haven’t kept up with the stock price), its dividend yield is lower, and shareholders’ risk aversion – a necessary ingredient for good returns – has melted into complacency.
“The higher the better”
We all love dividends, but too many investors choose stocks based solely on yield. This focus is a problem because, unlike it is for a bond, yield is not a measure of value for a stock. A company’s worth is derived from its potential to earn profits into the future. Dividends are simply the portion of those earnings that get distributed to shareholders.
If you want to focus on dividend income, start with a list of stocks that have an acceptable yield. From there, build a diversified portfolio of holdings that are trading either at or below what they’re worth.
“In your RRSP?”
When asked, “What should I do in my RRSP (or TFSA),” I have only one answer. The most important factor driving your RRSP strategy is the strategy you are pursuing for your overall portfolio (including other registered accounts, taxable accounts, pensions, and income properties). Anything you do in your RRSP has to roll up into your household asset mix. In this vein, RRSP contributions are a wonderful tool for adjusting your overall portfolio because transactions have no tax consequences.
Investing is hard enough as it is without basing decisions on false premises. So, if you find yourself listening to someone pontificate about where the market is going, try to change the subject or look for an escape.
Sources: The Economist, The Guardian, Les Affaires, BNN Bloomberg, La Presse, Reuters.